Why We Should Worry About a New Global Currency War

After five years of secular strength in the Dollar, the Trump administration seems intent to weaken its currency through unilateral measures. The possible implications should not be underestimated.

William R. White

Deutsche Version

The expression «currency war» conjures up a scary 1930's image of competitive devaluations (against gold) designed to divert a larger part of globally stagnant demand to individual countries at the expense of others. Then – as today –, such fears have been exacerbated by the prospect of «trade wars» as well.

William R. White

William R. White was chief economist of the Bank for International Settlements (BIS) in Basel from 1995 until his retirement in 2008. He was one of the few who had warned of the dangers of a global financial crisis before 2008. From 2009 to 2018 he was Chairman of the Economic and Development Review Committee of the OECD in Paris. He is currently a Senior Fellow at C.D. Howe Institute in Toronto. White began his career in 1969 as an economist in the service of the Bank of England and has fifty years of experience in monetary policy. He has published widely on topics related to monetary and financial stability. He lives in Toronto, Canada.
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However, the currency problems we have faced in recent decades have been different from those in the 1930’s in at least two important respects.

First, when the Brazilian Minister of Finance accused the United States in 2010 of beginning a «currency war», it was in response to a declining Dollar prompted by aggressive monetary easing on the part of the Federal Reserve. Since that easing might have been expected to increase aggregate demand in the US, and imports as well, it is not obvious that US policy at the time was detrimental to other countries.

Second, countries outside the US have not tried to reduce the value of their currencies in a retaliatory way. Rather, they have shown a marked unwillingness to accept an appreciation of their currencies, essentially against the US-dollar, whenever market forces wanted to push them upwards. Essentially, they have linked themselves to the dollar.

As a result, easy monetary policies in the United States have led to easier monetary policies elsewhere. Not surprisingly, the domestic imbalances once confined to the United States – rising property prices and high levels of debt and financial leverage – are now increasingly common in parts of Europe, China and many emerging market countries.

Learnings from the Asian Financial Crisis

What accounts for this «fear of floating» as the dollar was going through a secular weakness from 2002 to around 2014? Most other countries faced similar problems to the US, i.e. inadequate domestic demand and inflation levels that were deemed too low. Evidently, currency appreciation only exacerbated these problems.

Further, stronger currencies threatened the export led growth strategies first pioneered by Germany and Japan after World War ll, and then subsequently adopted by China and many others. A final concern was that holdings of dollar denominated assets, especially foreign exchange reserves, would lose value as domestic currencies rose.

In response to these exchange rate related concerns, some countries – mostly emerging markets – turned to foreign exchange rate intervention and administrative controls. Others – mostly advanced markets – eased monetary policy more or less in lockstep with the Federal Reserve.

Direct intervention in emerging markets was justified in terms of the need to build up foreign exchange reserves, as insurance against future crises, and the need to avoid market «overshooting». This was a learning they took from the Asian Financial Crisis of 1997.

Elsewhere, mainly in Europe and Japan, policymakers justified their unprecedented monetary easing by levels of domestic inflation that were sometimes only decimal points below their target levels.

This aggressive response seems hard to explain given the arbitrariness of the target level, how little we know about the welfare effects of moderate inflation or deflation, and increasing scepticism about the capacity of central banks to influence domestic prices in the face of global forces. It is therefore not hard to imagine that other motives, including concerns about the exchange rate, were also in play.

Trump abandons the «strong dollar» narrative

Since 2014 the dollar has once again strengthened against other currencies. In part this has been due to relatively stronger growth in the US, particularly against other advanced market countries, and relatively higher interest rates. Tariffs introduced by the Trump administration, along with significant fiscal stimulus from the 2018 tax cut, also help to explain the most recent dollar strength.

The reaction to this strength has, perhaps not surprisingly, been very similar to that of other countries in the earlier period of dollar weakness. The Trump administration has been and is discomforted by the dollar strength and has shown this in a variety of ways.

President Trump seems to have abandoned the «strong dollar» narrative of the last 25 years, agreed to by previous Democratic and Republican administrations. There have also been suggestions within the administration that exchange rate «underappreciation» be treated as a countervailable subsidy, and that foreign exchange rates be subject to dispute resolution. Finally, China has recently been labelled a «currency manipulator» by the U.S. Treasury, consistent with the Trump administration’s relentless focus on bilateral trade relationships.

Almost all economists would agree that most of these suggestions are misguided at best and dangerous at worst.

It is against this backdrop that concerns have again been raised that the US might unilaterally seek to lower the value of the dollar. These concerns would likely intensify if the US economy threatens to fall into recession. The U.S. Treasury could signal its intentions by using the Exchange Stabilisation Fund to sell dollars. More substantially, it could also call on monetary policy to ease further with a view to getting the dollar down.

While it might be countered that an «independent» Federal Reserve would resist such a call, President Trump’s unprecedented attacks on the Fed in recent months brings that comforting assumption into question.

Prepare for an imminent slowdown

There are many compelling arguments to suggest that such unilateral action would be unwise. First, there is no strong evidence that the dollar is significantly overvalued today. Indeed, as a percentage of GDP the US current account deficit has been falling in recent years.

Second, such a movement would invite retaliation, implying that the desired effect on reducing the current account deficit further would not be achieved. Third, other measures to reduce the US current account deficit could easily be suggested, not least more fiscal expansion by other countries running large current account surpluses.

In any event, many European countries, both large and small, should already be re evaluating the suitability of their fiscal frameworks in the face of a potentially imminent global slowdown. Helping avoid a global currency war through a measured fiscal expansion would simply be the icing on the cake.

A disorderly end to the dollar regime?

Should the US act unilaterally to weaken the dollar, and should other countries retaliate, this would constitute a profound change to the international monetary order. The possible implications should not be underestimated.

One possibility is that it might lead to a disorderly end to the current dollar based regime, which is already under strain for a variety of both economic and geopolitical reasons. To destroy an old, admittedly suboptimal, regime without having prepared a replacement could prove very costly to trade and economic growth.

Perhaps even worse, conducting a currency war implies directing monetary policy to something other than domestic price stability. There ceases to be a domestic anchor to constrain the expansion of central bank balance sheets.

Should this lead to growing suspicion of all fiat currencies, especially those issued by governments with large sovereign debts, a sharp increase in inflationary expectations and interest rates might follow. How this might interact with the record high debt ratios, both public and private, that we see in the world today, is not hard to imagine.

In short, starting another currency war would indeed be a very bad idea. Let's hope the relevant decision makers in Washington know that, too.